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Wednesday, December 10, 2014

Peak Oil And The Cycle

One of the things that are often misunderstood about "Peak Oil" is that it is not a prediction that oil prices will rise up in a straight line. Recent events have definitely thrown cold water on that interpretation. I will make a brief explanation why "Peak Oil" is not proven incorrect by the latest price swoon, and some comments on the economic effect of cheaper oil. I do not know whether the positive or negative effects are greater for the United States, but I think the reaction of the Canadian dollar provides a good read on the situation in Canada.

Peak Oil Recap

What I view as the most important components of the Peak Oil school of thought are:

the productivity of new energy sources (including oil wells) is dropping in economic and net energy terms;

cheap energy, particularly oil, is embedded as a component throughout industrial processes;

there are no technology fixes that will greatly increase energy efficiency or to provide new sources of concentrated energy.

The implication of these arguments is that global energy production will peak, and then decline. Note that some of these are negative arguments ("no technology fixes exist") which cannot be proven to be true; all that can happen is that they can be proved wrong. Despite decades of work on alternative energy, they are still holding up.

The best summary of the situation is that conventional oil production has peaked, while total global energy production is growing very slowly. Roughly speaking, we are in a "temporarily high plateau" of energy production.

The collapse in oil prices will neuter new investment, and so oil production will put in another peak within a few years, and then roll over. Depending on the trauma experienced by fracking operators, we may not see such exuberance in drilling for quite some time.

If the global economy was growing strongly, energy demand would presumably rise as well. This rising demand would run into the plateau-d supply, and higher prices is what one would expect. This is what happened in 2008 (although speculation likely helped).

Falling prices are therefore easy to explain - the global economy, hence energy demand, is not growing very fast. Most estimates indicate that there is a surplus of about 1 million barrels a day, or less than 2% of daily production. Once storage facilities are filled up, an excess of production poses obvious problems to prices. For a variety of reasons, no producer is willing to cut production, and all that we can do is wait until some big producer fails financially, and takes out the excess production. Alternatively, demand could rise rapidly, but it would be difficult for demand to catch up to what is happening on the supply front.

(I would note that Warren Mosler has a different take on the oil situation. He argues that Saudi Arabia acts as a price setter, and essentially administers the price of oil. There are limitations to this control of course, and there can be considerable divergences between different regions and grades of crude. His analysis of the futures curve shows that there is a spot shortage of oil. I do not have enough information or experience to disagree with him. However it seems safe to say that Saudi Arabia would not be able to drive drown the price to this extent in an environment of strong global demand for oil.)

Given the contractionary biases of policymakers in the developed countries, this situation could be sustained for some time. But like the 1990s, this will only offer a temporary respite from what is happening on the supply side, particularly if exploration is cut back.

Economic Effects

In a place like Japan, falling oil prices appears to be quite positive for the domestic economy. The only risk for Japan is its export industry. However, it will be difficult for yen weakness to be sustained in the face of falling oil imports.

The situation in the United States is more complex. There are some offsetting effects:

Bullish for the economy. The United States is a major oil importer (despite strange propaganda about "energy independence"), and falling oil prices reduces the oil import bill.

Bearish for the economy. The "fracking" boom was a major source of investment, which has an "accelerator effect" on the economy. Investment will reverse, which will hit GDP growth. Additionally, there will presumably be job losses, but the energy sector is still a relatively small employer. There is an additional wild card of energy high yield defaults.

I do not have the data to make a good estimate of what the net effect is. Historically, the bullish factor was the most important, since energy investment had been small for decades. The increased size of the energy sector means that any simplistic regression of energy prices on GDP growth will be misleading.

The effect of any high yield defaults is even harder to judge. The dollar amount of potential defaults are almost certainly trivial when compared to the aggregate credit risk in the fixed income complex. But it seems that a cluster of defaults causes complete disarray amongst high yield investors, and a general flight-to-quality episode could take hold. One would think that investors would have learned lessons from the financial crisis, which was less than a decade ago. But as would be expected of a follower of the economist Hyman Minsky, I am not too optimistic about investors' aggregate learning abilities.

So far, I see no reason to throw in the towel on the somewhat hawkish scenarios I outlined in my recent Fed Outlook. I still think that job growth has enough momentum to keep going despite sectoral problems.

Canada - Less Optimistic

As is typical, I am more bearish on Canada than the United States. The price for the sludge pulled out of the Tar Sands has dropped to $50 a barrel, and the Albertan economy is staring another ugly retrenchment in the face. Canadian bonds are at what used to be considered crazy JGB-like levels (at the timing of writing this, the 10-year yield is at 1.89%), and so it appears that the bond market agrees with my assessment. Meanwhile, the Canadian dollar is reacting and shedding its over-valuation.

The real worry in Canada (outside of Alberta, which will be a write-off if oil does not recover) is the housing market. Calgary is one of the three big cities which have buoyant housing (the others are Toronto and Vancouver). An meltdown in Calgary could easily spook the national lenders.

As shown above, detached housing starts have already corrected, at an annual pace near 60 thousand units, versus 100 thousand units seen in the early 2000s. Multiple units - mainly condos - remain strong, but the condo market probably will only crack when lenders are no longer willing to back speculators. (The United States had exactly that form of a delayed reaction in condos.)

If the Fed hikes, there will be noises about the Bank of Canada (BoC) following with a lag. Although that would be the usual BoC reaction function, the carnage in the oil patch may upset that scenario.

3 comments:

I spent a few minutes in a Google information search on 'stripper well economics'. My thought was that as oil well production fades, small but marginal operators take control of the wells. How do they react to declining prices?

My conclusion was that they close and may abandon the wells Economic logic applies here. If the price dip is only for days, the owner may lose money for a short time but once storage is full, the owner will shut down well operation and may (in finality) cap and abandon the well.

During this oil supply side play-out, the consumer will be enjoying lower oil prices which will allow easier (and likely increased) oil consumption.

Over some time period, the increasing consumption will meet the decreasing supply, and evidence will indicate that another oil search effort is warranted. Considering that oil is a 'big-time' item in the modern world, a world wide search for more oil is a massive undertaking requiring (again) higher prices for oil (to slow consumption) and massive shifts of employment and material flow.

In conclusion, the world seems to have just completed a successful search for more oil. Now, with more oil discovered and flowing, the world economy can go back to enjoying the fruits of the oil seeking effort (for a while).

Can you put the 1 million barrels of oil over supply in to context? When you look at this amount against total world oil demand, the 1 million barrels is a very small percentage of the total. And this is using numbers derived from $90 oil.

Working from memory, global oil production is between 70-80 million barrels per day. (I am busy right now and do not have time to track down the data.) As I noted, that means that the 1 million barrel over supply is less than 2% of supply (in fact, closer to 1%). In other words, not very large.

The problem is: where do you stick the excess? Once you overrun storage capacity, it is hard to deal with. This is unlike financial markets. Even gold is fairly easily stored; some in India use gold jewelry as a store of value. If you start getting close to storage capacity (or look like storage is emptying, going in the other direction), prices move a lot. You also see this in North American natural gas.

The response is also somewhat asymmetric, as an oil price spike will cause people to react quickly, but falling prices takes time to cause a reaction. I certainly will not start driving more because of a dip in gasoline prices.

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